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CHAPTER
Equity Financing
In the preceding chapter the processes by which risks of losses resulting from
changes in price are shifted from one group of people to another were described. It is clear that the need to shift risks was the original impetus for the
development of the markets and that, for more than a century, hedging of price
risks has been the dominant force in determining the size of the markets and the
fluctuations in the level of trading. However, this description does not explain
why the activity takes place; why some businessmen involved in commodity
production, marketing, and use have a compulsion to hedge risks while others
do not. To observe the practice is useful and adequate for understanding the
past and present. It is necessary to inquire into the motivations of hedgers and
the institutional arrangements lying behind the hedging activity if we are to
fully understand the why of that which has taken place and to make progress in
charting the course that lies ahead.
Financial Instrument
A futures contract is a financial instrument and futures trading is a financial
institution engaged in gathering and using equity capital. It is not a financial
institution in the sense of a bank in which money is received from one group of
people and loaned to another. Rather, it is a means by which loans made by
banks or operating money otherwise secured by businesses is guaranteed against
loss. When bank loans, or capital from any other source, can be protected from
part or all of potential losses they are more readily forthcoming than when they
cannot. Operating businesses acquire debts that they add to their own net worth
to build a total operating capital structure. By this process, they can control
capital without owning it and the people from whom they obtain funds can own
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capital without administering its use. The financial system is the means by
which the ownership of real capital is separated from its control. Futures
markets are a part of the system. In this context, a futures contract is the
exchange of a monetary obligation, or debt, for a commodity obligation, or
debt. The long speculator exchanges his own monetary obligation to pay for the
commodity for the obligation of the hedger to deliver the physical commodity.
The short speculator exchanges a monetary obligation to buy and deliver for the
commodity obligation of the hedger to accept and use the commodity. Thus, the
hedgers remove themselves from financial debts by substituting commodity
debts for them. The financial obligations are assumed by the speculators.
This process of debt exchange through the financial system enables resources
to be used more productively and it is from this that the social benefits of the
financial system flow. The consolidation of resources through the exchange of
debt enables increased productivity associated with large scale enterprises. The
ownership of scarce resources is widely diffused and, if it were not possible to
consolidate their control, production would be quite as diffused as ownership.
This would result in small-scale production, limited technological advance, and
less total productivity. Control of capital needs to be consolidated into the hands
of the people who can use it most efficiently and people who can operate
businesses most efficiently need access to capital beyond their own equity.
In the last chapter we tended to look on speculators as the people who
accommodated the hedgers in a null fashion, appearing when and only as
needed. As we turn to borrowing money from banks to finance stored inventories, we tend to merely note that warehousemen who have their inventories
hedged can borrow more money than those who don't. This does not do justice
to the speculator. By committing his wealth to commodity futures he influences
the warehousing activity and its cost, and, thus, becomes an important financier.
Financing Process
The process by which equity capital is raised through futures trading can best
be seen by some examples. First, the importance of hedging in financing stored
inventories of grain has long been recognized. Terminal elevator operators,
cotton merchants, grain processors, and, to a lesser extent, country grain
warehousemen are often able to borrow in excess of 90 percent of the value of
stored commodities at prime rates of interest, providing the inventories are offset
by short positions in futures markets. Warehouse receipts serve as collateral for
the loans so that the general balance sheet and liquidity of the company are not
affected by the inventory ownership except for the small difference between the
value of the cash commodity and the amount of the loan. In some cases in
which the capital position of the company is so fully extended before borrowing
to buy inventory that the commodity loan would restrict financing of noninven-
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tory activities, separate warehouse companies are established or a system of field
warehousing is used. In such cases the commodity inventory does not enter the
balance sheet.
The inventory loans are sometimes worked up to quite high levels. Banks
frequently loan the margin deposit on the futures transactions as well as a high
proportion of the current value of the inventory. Or, they loan the full value of
the inventory on the basis that the margin deposit is quite enough protection. As
we shall see when we consider hedging operations, the value of stored commodities tends to increase in relation to the futures price as the storage season
progresses. For example, corn in country locations may sell 40 cents under the
July futures price at harvest and typically sell for 5 cents under the July on July
1. There is thus a highly probable 35 cent storage profit in a hedging operation.
Armed with this information, the country elevator operator may go to his
banker and ask for the full purchase price of the corn, the margin requirements,
and a part of the storage earnings and thus finance part of his operating costs in
addition to the inventory. Bankers are not inclined to go so far, but the operator
may get away with the full purchase price and margin plus a promise of the
storage earnings as they accrue.
As time passes the price of the commodity, hence, the market value of the
warehouse receipts, changes. If the price goes down, the bank, reasonably, wants
part of its money. It is readily available out of the increased value of the short
futures position. The warehouseman asks his commission futures merchant for
the money the bank wants. If the price goes up, the short futures position shows
a loss and the commission house calls for margin. The value of the warehouse
receipts has increased and the additional margin is forthcoming from the
banker.
The point of this is that ordinary bank financing is readily available for
purchase and storage of hedged inventories. This is not the case for unhedged
inventories. The transaction is put on the balance sheet and a normal liquidity
margin is required. The proportion of the loan may be sixty percent or so-—certainly, a great deal less than for hedged inventories. The equity capital that the
operator must furnish is very much less for hedged than for unhedged inventory. The uncertainty of the warehouseman's return is reduced by hedging but
the total uncertainty of the venture is not. The fact remains that the market
value of the commodity may decline so that the return to storage may be less
than zero or it may increase so that the return is much more than the cost of
storage. Commodity price variations are great relative to the cost of storage.
Losses are taken out of someone's equity and gains are paid into someone's
equity. As we have seen, on the other end of the hedges stand the speculators.
The flow of funds from commission house to warehouseman to bank or from
bank to warehouseman to commission house as prices decline or increase, flows
further to the clearing house and from then on to the speculators, decreasing or
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increasing their equity. The speculator is thus a financier, furnishing the equity
capital required to absorb changes in price level.
This process of financing is roundabout and specialized. It would be theoretically possible for the warehousemen to go directly to individuals for the money,
selling them warehouse receipts and charging them storage. The individuals
would, in turn, go to banks and borrow, on the basis of their net worth, the
money to buy receipts. It would be a clumsy system with banks making many
small loans to speculators instead of a few large loans to hedgers (note the
relative size of positions of hedgers and speculators shown in Chapter 6 ) .
More importantly, it would have little attraction to speculators because they
would be furnishing the total of the funds rather than the equity necessary to
finance price variations. Further, it is difficult to visualize such a scheme sufficiently sophisticated to afford liquidity comparable to that of futures trading.
More likely, the warehousemen would reorganize the financial structure of their
businesses in a way that would make the assumption of equity financing
possible.
As developed in Chapter 4, futures markets originated out of a need by
country merchants for equity capital just as egg warehousemen turned to their
friends for the equity capital to carry inventories. It is worth noting they did not
necessarily lack the net worth to obtain funds from the banking system; in the
case of eggs, net worth was more often adequate than not. They simply preferred not to endanger their capital structure to the extent they judged the price
risks of a full inventory would endanger it. The system evolved over a long
period of time as the most attractive among the alternative ways of gaining
access to equity capital.
A second example relates to cattle feeding. The production of market beef is a
two stage process. The animals are raised from breeding herds on the grazing
lands of the west and south and moved into specialized feeding yards or on to
grain producing farms for further growth and fattening. The traditional pattern
was from the forage producing lands of the plains and mountain states to the
corn production lands of the central states, particularly Iowa and Illinois, and
then on to the central markets for slaughter and shipment to eastern consumption markets. The farmers buy feeder cattle, feed them grain and other concentrates, and sell them for slaughter. Their profits and losses depend on their skills
in feeding cattle and on the price of fat cattle in relation to the cost of feeder
cattle and the cost of feed. The feeding process takes time (up to 12 months
and an average of about 6) and the price of fat cattle fluctuates over wide
ranges. Thus, cattle feeders are exposed to substantial amounts of risk unless
they develop some kind of a risk shifting program.
In this traditional feeding process, the farmers are part cattle feeder and part
cattle speculator. Some follow the same pattern, year in and year out, buying the
same size and quality of feeders at the same season each year and feeding them to
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the same weight and quality for sale. For these people, variations in the feeding
margin average out over a number of production cycles so that, in the long run,
they get the industry average returns (plus or minus their own technological
skills in relation to those of the industry). But the long run may be several years
so that a large reserve of equity capital is necessary for survival. These people
are speculative nulls. Most cattle feeders, however, vary their operations on the
basis of existing and expected prices and price relationships, becoming active
participants in the speculative game. They buy different sizes, kinds, and qualities of cattle and sell at different weights and qualities in different production
cycles. At times, they leave their lots empty and sell part of the feed supplies
that they have produced on their farms, and at other times, they increase the
size of their operations and buy additional feed. The extent to which programs
are varied differs greatly within the cattle feeding fraternity. Some of the members are more speculator than feeder.
In the main, the equity base of the traditional, midwest cattle feeders is large
enough that they can readily absorb the risks associated with the business and
can command the necessary capital to finance the operations.
Starting in the latter 1950's the industry changed rather dramatically. Beef
production nearly doubled from the early 1950's to 1975. Part of the increase
was the result of increasing cattle numbers, but a substantial part of it was the
result of putting more cattle through the feeding process so that slaughter
weights were increased. Many of the small feeding operations went out of business. Large scale, commercial feedlots were developed. By 1968, the proportion
of cattle fed in the traditional, small operation had decreased to about one-half
and the other half was fed in commercial feedlots (1,000 or more head per
year). Nineteen of these fed more than 32,000 head per year. The heaviest concentration was in yards of 8 to 32 thousand.
The increase in scale resulted in a new set of risk and financing problems.
The equities of the firms would not support risks associated with price variability
nor did the firms want to take as large risks as they could. The practice of
custom feeding developed, in which the cattle are owned by someone other than
the feedlot and the feedlot is paid per pound of gain or feed cost plus overhead.
The risking-financing activities are carried by .someone other than the feedlot.
The cattle owners are speculators. By the late 1960's, approximately one-half of
the cattle on feed in commercial feedlots were custom fed.
The cattle custom fed are owned by ranchers, cattle feeders, meat packers,
livestock marketing agencies, and investors. Many of the cattle feeders and investors use the operation in part as an investment and in part as an income tax
shelter. They obtain leverage by borrowing from banks. The price of cattle followed a generally upward path from $25 per hundred weight in I960 to an
average of $36 in 1972 and to a peak of $60 in the summer of 1973. The investors pyramided successfully. The price of cattle collapsed in 1973. The in-
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ventory value of all cattle and calves in the U.S. decreased from $40 billion on
January 1, 1973 to $20 billion on January 1, 1974. Heavy losses were taken and
many loans could not be repaid to banks. The tax shelters work well in the context of tax avoidance, but poorly in the context of preserving income.
It was in this context that futures trading in live cattle was started in 1964. It
grew rapidly to an average open interest of 18,265 contracts of 40,000 pounds
each (38 fat cattle) in fiscal 1968-69. The average open contracts and reported
short hedges were:
Fiscal
Year
Open
Interest
Short
Hedges
1968-69
1969-70
1970-71
1971-72
1972-73
1973-74
1974-75
18,265
21,564
13,638
18,752
28,217
32,830
26,434
6,982
4,839
3,709
4,233
8,494
7,827
11,320
The impact of the price decline of 1973-74 is readily apparent in the increase
in short hedges. The feedlot operators shifted from individual investors to the
futures market as sources of equity capital. The bankers were a strong force in
the shift. When their loans to feedlot operators are secured by futures contracts,
they avoid the credit risks that were troublesome and in some cases, ruinous, in
1973-74. The equity capital is furnished by the speculators in futures markets.
Pyramiding of Capital
The command of resources can be greatly increased by hedging inventory
risks or by pricing finished product before operating costs are committed. A loan
rate of 90 percent on hedged inventory enables a firm with $1,000 of equity
capital to contract and use, in a storage and merchandising activity, $10,000
worth of a commodity. A loan rate of 60 percent is two thirds as much, however, it enables the control of only $2,500 of inventory. Thus, the increase in the
borrowing rate from 60 to 90 percent enables the control of four times as much
capital. This is illustrated here at a 60 to 90 increase so that the numbers remain
finite. As we have seen, a 60 to 100 increase is feasible in which case the equity
capital requirement for price protection is zero and the multiplier is infinite.
Constraints on the growth of the business are from sources other than equity
capital for inventory control.
The impact of equity financing through fixing sales prices of products ahead
of production is equally impressive. Suppose that a corn producer is operating
1,000 acres and is contemplating expanding to 2,500 acres by leasing additional
land. His lease cost is $100 and his operating cost other than return on fixed
investment in machinery and equipment is $100 per acre, his anticipated yield is
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100 bushels, and the net price that can be obtained is $2.50 per bushel. He thus
has a prospective operating margin of 50 cents or a total of $125,000 compared
to a current $50,000. He will use up virtually all of his balance sheet, liquidity
in the purchase of additional equipment. He has to furnish a bank guarantee for
payment of the lease. How much of his own equity must he hold for operational
costs ? It depends on the percentage loan. Price vulnerable, the bank may loan
60 percent, requiring $100,000 of operator equity but not price vulnerable the
bank may go 90 percent, requiring only $25,000. This latter amount is not
really a price vulnerability equity but rather a guarantee of the organization and
management skills of the operator in the production process—his technical
ability. If his past performance record is excellent, the bank may loan the whole
of the operational cost and the lease guarantee.
The ability to obtain the operating capital is not the only consideration in
fixing sales prices. It protects the operator from his own mistakes. The market
may not offer a price as high as $2.50, making the expansion less attractive or
possibly unprofitable. The operator may optimistically—as is the nature of
farmers—expect the price to eventually turn out to be $2.50, commit his own
equity, and fail. If the futures market won't furnish the equity and he can't
otherwise obtain it, he the operator, is protected.
More importantly, the process protects the equity capital of the operator. He
may not elect to make the expansion if it must be done at the hazard of his
equity. He may be willing to hazard his net worth on his ability as a corn producer but not as a corn speculator, especially if he recognizes that he is tied to
the long side of a speculation with no flexibility. He would be long 250,000
bushels of corn, throughout the production period and thus a speculator on the
price of corn. The old 100,000 bushel level may be more attractive. If this is the
case, the expansion may not be made. Equity capital from futures markets may
affect the business structure and efficiency of corn production. This is but one
example. Others can be drawn from all commodities actively traded.
Attraction of the Speculator
There is something ridiculous about explaining to a chemist or a private
detective that he, fine and noble entrepreneur, is furnishing the equity capital to
feed cattle or produce plywood. Told, he is apt to reply, "Who, me? I'm just
trying to make a fast buck in a market where I can get high leverage on money
that I am willing to lose (heaven forbid)." Shades of Adam Smith's invisible
hand.
This process of equity capital flow from speculative markets is an example of
commercial specialization among financial institutions. The process of gathering up money is separated from hazarding equity. One is the business of the
banking system while the other is that of speculators.
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The division and specialization is the thing that attracts speculators. Had they
to furnish the whole of the operating capital to produce corn or buy feeder
cattle there would be little attraction. They are only interested in furnishing the
equity and taking the risks. A high proportion of commodity inventories for
which futures markets exist are hedged. But only a small part of the production
of corn, cattle, plywood, orange juice, etc. are forward priced in futures
markets; the equity capital is otherwise forthcoming. How good the futures
system is compared to others is a question that can only be answered after more
of market operation has been considered. As we proceed, we will note that the
cost of equity capital is very near zero and more likely negative than positive. A
zero or negative interest rate on high risk capital compared to a bank interest
rate on nonrisk capital is an interesting anomaly. Such is the behavior of speculators.